Financial Analysis: Accounting for Changing Price Levels Is a Far More Interesting and Relevant Subject Than Many Students Expect. the Examiner Reveals Why It's Also Easily Examinable

Financial Management (UK), July-August 2005 | Go to article overview

Financial Analysis: Accounting for Changing Price Levels Is a Far More Interesting and Relevant Subject Than Many Students Expect. the Examiner Reveals Why It's Also Easily Examinable


The measurement of income and capital occupies 20 per cent of the syllabus for paper P8, covering such complex topics as financial instruments, substance over form and accounting for pension schemes. This section is split into six learning outcomes, the second of which is: "Explain measures to reduce distortion in financial statements when price levels change." Many students, especially those who work in the UK and other economic regions where prices vary little from year to year, may wonder why this outcome appears at all. They may be tempted to dismiss it as being of such little importance that it's unlikely to be examined.

There are two main reasons why the learning outcome is examinable. First, it's in the syllabus, so it's just as likely as any other to be examined. The only areas covered in the syllabus that are viewed as falling outside the scope of examination are those where an accounting standard has altered conditions so that the topic is no longer viable. A good example of this point is provided by section A of the syllabus. At the time it was published, the pooling-of-interests method of accounting for business combinations was still permissible under IAS22. But, in line with the publication of IFRS3 and recent changes to US regulations, the method is no longer permitted. It's hard to envisage conditions changing to the point where that prohibition would be relaxed globally, so pooling of interests can properly be regarded as defunct and, therefore, no longer examinable.

The second reason why this learning outcome is examinable is that the topic of accounting for changing price levels is valuable, both practically and conceptually, to the management accountant. You might well ask where the practical value of learning about accounting for changing price levels could lie when the issue of price inflation seems to be a thing of the past, but it's important to apply some longer-term thinking to the issue. When I trained as a chartered accountant in London many years ago, accounting for changing price levels was probably the most pressing issue in accounting. My salary rose by more than 30 per cent in the final year of my training contract. Much of this increase was an adjustment to reflect the extremely high rate of inflation at the time.

The following year, when I took out a mortgage on a two-bedroom flat in Paddington, west London, costing 16,000 [pounds sterling]--those really were the days--the interest rate was more than 15 per cent. It would have been unbelievable at that time if some crystal-ball-gazer had told me that inflation would be brought under control in a few years and fall to levels of as little as two to three per cent each year. Nevertheless, that's what has happened. So, it doesn't do to assume that economic conditions will remain the same inclefinitely. A management accountant qualifying in the next couple of years could still be hard at work in 2050. Who can say what economic conditions will prevail over that person's working lifetime?

Another important point is that, even at two to three per cent annually, changing price levels do have a noticeable effect over even a relatively small number of years. It's no bad thing to keep aware of the potential impact. Also, economic conditions can vary greatly around the world. Just because inflation rates are currently low in much of western Europe, it doesn't mean that the same conditions prevail throughout Asia, Africa and the Americas. It is certainly possible that management accountants will have to understand and deal with the impact of changing price levels in subsidiaries and branches in locations remote from their own field of experience.

Conceptually, accounting for changing price levels is of great interest. Where inflation (or deflation) is an issue the relevance and reliability of traditional financial statements prepared on a historical cost basis is called into question. But making pricelevel adjustments is not straightforward. …

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